DESCRIPTION: A diagonal call spread is a combination of a vertical call spread and a short calendar call spread. As a result, it takes on the characteristics of both structures, namely directionally bullish, short volatility with little, no or even positive time decay.
MOTIVATION: The investor wants to take a bullish position in a stock using options, but seeks a strategy that has less time decay than a traditional vertical call spread. Short dated options decay faster than long dated ones. As a result, a diagonal call spread will have less time decay than a vertical call spread. But just like a vertical call spread, the structure uses different strike prices to capture a directional movement.
OUTLOOK: The investor who buys a diagonal call spread believes the share price will rise over the life of the short dated option sold. At this point, the investor has a number of choices they can make. The can (1) close the trade. (2) If they are still bullish the underlying security, hold on to the longer dated option and close the short dated upside call or let it expire worthless. (3) Roll the spread into a new one adjusting the strikes for the current market conditions.
MAXIMUM GAIN: (Higher Strike – Lower Strike) – Premium Paid
The most an investor can make on a diagonal call spread is equal to the difference between the two strikes less the premium paid when putting on the position.
MAXIMUM LOSS: Premium Paid
The maximum loss occurs when the price of the underlying falls so much that the value of the two options effectively goes to zero. Under this scenario, the loss would be the premium paid upfront.
BREAKEVEN: Not well defined
Since the options differ in their time to expiration, the level where the strategy breaks even is a function of the price of the longer dated option at the expiration date of the shorter dated option. In any case, the breakeven would be somewhat above the strike of the lower strike option.
VOLATILITY: Positively correlated. An increase in implied volatility, all other things equal, would have increase the value of a diagonal call spread. Longer dated options have a greater sensitivity to changes in market volatility (vega).
TIME DECAY: Time decay works in favor of the structure. Since shorter dated option decay faster than longer dated ones, the value of a diagonal call spread will decay much slower than a single leg option and can even enjoy price appreciation depending on the differences in the time to expiration and strike prices selected.
ASSIGNMENT RISK: Early assignment is always a possibility with an American style option. If the owner of the short dated option exercises their right to buy stock, the investor in a diagonal call spread will have to buy the stock back in the market or exercise their longer dated option to make delivery without borrow stock.
EXPIRATION RISK: Concerns what happens at expiration, which may not be in the control of the investor. Should the shorted dated call get exercised at expiration, the longer-term call option would still be in place to provide a hedge. If the longer dated option is held to expiration, the investor is in control of the exercise decision.